The 1986 Tax Reform Act was enacted on Oct. 22, 1986.
The goal was to simplify the tax code and to reduce individual tax rates. The current tax rates are lower than the pre-1986 top marginal rate of 50%. However, the Act had originally lowered the top marginal rate to 28%, but it has crept up over the years to the current 35% (or 39.6% if the Bush Tax Cuts expire).
Unfortunately, the tax code did not remain simplified. Over the past 25 years, an incredible amount of complexity has been written into the code. Some provisions satisfy legitimate goals such as accurately taxing global profits. Other provisions suffer from the problems of the past - penalties or rewards for specific taxpayers and needless complication. The code is overdue for another comprehensive reform.
The Tax Reform Act saw the birth of IRC 469 - the passive activity loss rule. This limited loss deductions on passive activities to the amount of gain from those activities. Meaning if you made $10,000.00 in a business you start that qualifies as a passive activity, you can only deduct expenses against the $10,000.00 earned.
Passive Activities are activities in which the taxpayer does not materially participate, as determined under the code. Losses will accumulate until the business is sold and only then can the taxpayer realize the loss against his income.
This reform was meant to prevent tax shelters. An example would be a ranching business owned by a CEO of a company. The CEO works full time for the company and only works on the ranch on weekends he can leave the office. Unsurprisingly, the ranch never makes a profit. Before IRC 469, the losses on the ranch would be deductible against his gross income.
By limiting questionable deductions, like passive activity losses, as well as limiting some corporate tax deductions, the reform act was able to be revenue neutral while lowering the tax burden on most Americans.
Showing posts with label 1986 Tax Reform. Show all posts
Showing posts with label 1986 Tax Reform. Show all posts
Thursday, October 27, 2011
The CBO is a Tool...
It can be used to enlighten or mislead. On Tuesday, the CBO released a new report on the the GINI distribution of income in the United States.
Here is the report and accompanying blog post. I'd recommend the blog post as it gets the point across neatly and the report is a healthy 50 pages of graphs and methodology. If you are interested, the report is a great resource on how many complications exist in an analysis on income inequality.
Oddly, the report compiles data from 1979 to 2007, before the current depression. Greg Mankiw, a Harvard Economics professor breaks down some of the more recent data, 2008-2009, to show how much an effect the choice of date had on the conclusion. If you go to figure 2 - pg. 3 of the report, the graph shows the volatility of high earner income, and the 2007 snapshot is taken at the peak, just before a massive trough.
Mark Perry, prior to the release of the CBO report had an interesting post on the cause of income differentials between quintiles of the American population - Household Demographics.
I'd like to take note of an additional cause for the inaccuracy of the report. The report makes note the composition of income in fig. 10, pg. 17. Business income has greatly increased as a share of total income for the top 1%, while capital income has decreased. This is due to the tax reform act of 1986, which made pass-through entities - S-corps, LLCs and Partnerships - more tax efficient than traditional C-corps.
This difference was not accounted for by the CBO. In 1979, a wealthy person who owned a business would pay corporate taxes (the current rate is 35%) on profits. The after tax remainder would go on their personal return as dividend income. This would mean that a company with $100 in profit would pay $35. It would appear as if the wealthy business owner received only $65 in dividend income (taxed at 15%).
If the same wealthy businessperson made the same profit in his new LLC, he would record $100 of business income. This would then be taxed at the current rate of 35%.
Without accounting for this difference, a business owner appears to be making $35 more on every $100 then they did in 1979, with no change of economic substance. 100/65 = 1.53x growth in "pre-tax" income for the wealthy who changed their corporate form but no increase in reality. Given the decline in capital income in favor of business income found in the report, the nature of accounting contributes a significant partial share in the increase in income for the top 1%.
Here is the report and accompanying blog post. I'd recommend the blog post as it gets the point across neatly and the report is a healthy 50 pages of graphs and methodology. If you are interested, the report is a great resource on how many complications exist in an analysis on income inequality.
Oddly, the report compiles data from 1979 to 2007, before the current depression. Greg Mankiw, a Harvard Economics professor breaks down some of the more recent data, 2008-2009, to show how much an effect the choice of date had on the conclusion. If you go to figure 2 - pg. 3 of the report, the graph shows the volatility of high earner income, and the 2007 snapshot is taken at the peak, just before a massive trough.
Mark Perry, prior to the release of the CBO report had an interesting post on the cause of income differentials between quintiles of the American population - Household Demographics.
I'd like to take note of an additional cause for the inaccuracy of the report. The report makes note the composition of income in fig. 10, pg. 17. Business income has greatly increased as a share of total income for the top 1%, while capital income has decreased. This is due to the tax reform act of 1986, which made pass-through entities - S-corps, LLCs and Partnerships - more tax efficient than traditional C-corps.
This difference was not accounted for by the CBO. In 1979, a wealthy person who owned a business would pay corporate taxes (the current rate is 35%) on profits. The after tax remainder would go on their personal return as dividend income. This would mean that a company with $100 in profit would pay $35. It would appear as if the wealthy business owner received only $65 in dividend income (taxed at 15%).
If the same wealthy businessperson made the same profit in his new LLC, he would record $100 of business income. This would then be taxed at the current rate of 35%.
Without accounting for this difference, a business owner appears to be making $35 more on every $100 then they did in 1979, with no change of economic substance. 100/65 = 1.53x growth in "pre-tax" income for the wealthy who changed their corporate form but no increase in reality. Given the decline in capital income in favor of business income found in the report, the nature of accounting contributes a significant partial share in the increase in income for the top 1%.
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